Market Commentary November 2018

Cornelian's Investment Team give their Market Commentary for the month passed and a detailed Investment Outlook, outlining the reasons to be optimistic about equity markets.

Equity markets fell heavily during October following comments from the Chairman of the Federal Reserve. This led to negative returns over the three months to the end of October. Equity market returns varied significantly by region over the period under review. The FTSE All-Share index (-7.8%) fell as market uncertainty intensified over the potential outcome(s) from UK/EU Brexit negotiations, ahead of critical deadlines later this year. The UK stock market remains highly out of favour with international investors given this uncertainty. UK equity market returns significantly underperformed the FTSE World ex UK £ Index (-3.1%). Of the major regional blocks, the United States equity market produced the strongest returns in Sterling terms (S&P 500 £ index, -0.7%). Companies listed in the United States are reporting strong earnings growth, benefitting from both corporate tax reform and accelerating economic growth.

Gilts produced a small negative return during the period (FTSE Gilts All Stocks Index, -0.5%). This mirrored negative returns in other major government bond markets where yields rose due to evidence increasing that developed market economic growth was accelerating. Investment grade debt delivered a marginally negative return (ICE BofAML Sterling Corp -0.1%), whilst ‘riskier’ high yield debt outperformed investment grade debt (BAML £ High Yield index, +0.4%).

During the 3-month period, the Brent crude price increased by 1.6%, finishing the quarter at $75.5 per barrel, despite some intra-period volatility. Venezuelan and Iranian sanctions threaten a reduction in the supply of oil as a time where the demand/supply balance is relatively tight.

Gold rallied somewhat in October as investors sought a safe haven from equity market volatility.

Gold rallied somewhat in October as investors sought a safe haven from equity market volatility. Nonetheless, the gold price fell -0.1% in US Dollar terms, to $1214.8 per ounce during the three months to the end of October. In Sterling terms, the gold price rose by 2.1% as the Dollar strengthened against Sterling over the period.

Investment Outlook

Equity markets fell sharply during October. Numerous suggestions have been put forward to account for the change in market psychology.

The two most commonly cited reasons for the sell-off are that recent Federal Reserve messaging suggests that interest rates in the United States will rise by considerably more than previously expected and that the IMF has downgraded its forecast for global economic growth.

It is true that the Chairman of the Federal Reserve said that current interest rates in the United States were a long way from neutral and they may take interest rates above the neutral rate if they thought fit. However, this is entirely in keeping with previous messaging released by the Federal Reserve in March and so shouldn’t be a surprise.

The IMF cut their global growth forecast from 3.9%pa for 2018 and 2019 to 3.7% and cited trade wars as a key reason for the downgrade. The IMF has a risible record of economic forecasting and so it would seem strange for investors to take too much notice of what the IMF has to say.

This means that we have to look elsewhere for reasons for the change in perception concerning the outlook.

We believe that the most relevant issue is that initial third quarter trading updates from economically sensitive companies have been mixed with those that are exposed to the global car market and semi-conductor sectors, in particular, reporting a difficult quarter. This has led some to suggest that we may be close to a peak in earnings for this cycle. We believe this is very wide of the mark and expect earnings growth to persist, albeit at a slower rate than the exceptional growth reported during the second quarter of 2018, where US companies, in aggregate, reported earnings growth of 25% year on year.

Allied with unease about the outlook for earnings is the fact that interest rates have risen in the United States to such an extent that it is now possible to buy Government debt with a yield of nearly 3% per annum, maturing in three years’ time. This compares with a yield of circa 2% for the S&P500 equity index. This means that US based investors, who are uncomfortable with the increased volatility of the stock market and would like to book some of the gains they have made over the past ten years, have a ‘risk free’ investment which will provide a return that is likely to match (or beat) inflation over the next three years. This has resulted in profit taking and has spilled over into other equity markets.

There are good grounds to be optimistic about the outlook for equity markets.

We take a different view and believe there are good grounds to be optimistic about the outlook for equity markets, notwithstanding the increase in volatility, which is likely to persist.

First of all, other traditional indicators of a reduction in risk appetite have not moved much. Whilst the cost of debt financing for higher risk companies has risen, it has increased broadly inline with Treasury yields such that the spread between Treasuries and high yield corporate debt remains narrow relative to history. Thus, investors in high yielding company debt are not anticipating a material worsening in the outlook and this seems fair to us, as we do not believe that the corporate debt default rate is about to rise from current levels. Furthermore, there is little sign of a loss in confidence concerning lending between banks.

It is true that US housing market activity is subdued due to rising mortgage costs, however it is, arguably, a good thing that the current US expansion is not reliant on a US housing boom. In aggregate, however, US economic data releases are tracking inline with expectations and, importantly, inflation expectations remain well anchored, which suggests interest rates in the United States are unlikely to have to rise by more than currently forecast by the Federal Reserve.

Globally, service sector confidence surveys continue to be robust. Manufacturing confidence surveys are strong in the US and Japan. In Europe, they remain positive but have come off the boil somewhat (probably as a result of the auto sector issues). Manufacturing confidence is least strong (ie. neutral) in China as a result of the trade tariffs and a slowing domestic economy. The Chinese authorities are now beginning to use both fiscal and monetary policy to stimulate economic activity and the results of this should soon be evident.

Despite the rhetoric, we expect a trade deal between China and the United States to be forthcoming post the US mid-term elections in November. Such an outcome would be a materially positive catalyst to share prices.

The oil price had hit a new high at the start of October, and this may well have triggered a reassessment of the impact of rising energy costs on some companies operating margins. Since then however, the oil price has retrenched back into its trading range.

Much has been made of the strengthening US Dollar and it is true that some emerging market currencies have fallen sharply against the US Dollar, but on a ‘trade weighted’ basis the US Dollar has not strengthened materially.

Customers will need to replenish stock levels and the positive impact of this on manufacturing company sales and margins is being underestimated by investors.

In the US, manufacturing companies are reporting that significant numbers of their customers believe that they are running with too little inventory following a period of stronger than expected demand. This suggests that customers will need to replenish stock levels and the positive impact of this on manufacturing company sales and margins is being underestimated by investors.

We believe that the observed strong growth in capital expenditure by companies will persist and that this will drive productivity gains, earnings growth and help ensure that underlying inflation remains ‘well-behaved’. Banks in the United States (and elsewhere) continue to make it easier for corporates to borrow and this underpins our confidence concerning the persistence of the economic upswing.

The recent equity market falls leave valuations at attractive levels. The FTSE All-Share index in now trading on a forecast 2019 dividend yield of 4.6%. We view this pull back in equity markets as more of a buying opportunity than something more sinister.